Be aware of risks when investing

Very few individual investors do as well as market indexes on a long-term basis. One major reason is that they fail to develop long-range plans, instead creating portfolios that require frequent major changes, which incur expenses and taxes.

By Elliot Raphaelson

recordnet.com

By Elliot Raphaelson

Posted Dec. 2, 2012 at 12:01 AM

By Elliot Raphaelson
Posted Dec. 2, 2012 at 12:01 AM

» Social News

Very few individual investors do as well as market indexes on a long-term basis. One major reason is that they fail to develop long-range plans, instead creating portfolios that require frequent major changes, which incur expenses and taxes.

If you are making dramatic changes to your portfolio and your returns lag the major indexes associated with your investments, then consider changing your approach. You have probably not looked closely enough at the risks that are relevant to your investments.

There are different types of risk - the major ones are interest rate, credit, inflation, currency and market - and any one of them may affect you differently than it affects other investors.

Interest rate risk can be understood by this inverse relationship: When interest rates increase, bond prices decrease, and vice versa. If you invest in bonds, changes in interest rates can have a significant impact on the value of your portfolios. Long-term bonds are much more volatile than short-term bonds.

Credit risk refers to the potential loss in investment value when a corporation's or government's credit rating is downgraded. After a debt rating downgrade, the value of an entity's outstanding bonds or preferred stock will immediately drop. A disadvantage of buying individual corporate bonds with low credit ratings (aka "junk" bonds) is that they are more likely than investment grade bonds to be downgraded.

Inflation risk is an all too familiar concept to savers today. Short-term investments such as Treasury bills and money market instruments currently yield less than 1 percent. Even if inflation is 3 percent a year - a historically low rate - a portfolio of these "safe" investments will erode in value by more than 2 percent a year. Investors with a significant long-term portfolio in these instruments will be losers.

Currency risk refers to the possible of loss in your portfolio based on changes in the value of currencies relative to the U.S. dollar.

Market risk refers to the possible investment loss due to fluctuation in security prices for other reasons. Fluctuations can occur within an entire asset class or for a specific security you own. When you invest in common stocks, you incur more market risk than you would for more conservative investments. The value of an individual stock may fall because of general market conditions, poor earnings, new tax regulations or unfavorable industry projections. If you invest in commodities, such as gold and silver, you are also subject to market risk because of the price volatility of the underlying commodity.

You have to take some market risk to obtain capital growth, but you shouldn't take more risk than you can afford. You should look at the price stability of any asset class you are considering investing in to make sure that you can afford short-term fluctuations in value, and thus do not have to bail out at the wrong time. Diversification is crucial.

When developing a long-term investment plan, take a hard look at the risks and make sure you are taking the right ones and avoiding the inappropriate ones.

For example, if you are in the early stages of your career and need to save for retirement, it doesn't make a lot of sense to have a large portion of your investment in low-yielding Treasury bills losing more than 2 percent a year to inflation. If you are near retirement, with a significant capital base, you should be more mindful of market risk - i.e., having too large a percentage in common stocks. If you are already retired and depend on bonds for recurring income, be wary of credit risk and avoid putting a large proportion of your bond holdings in individual junk bonds. Rather, you should consider either investment grade bonds or a conservative, high-yield fund.

With a good understanding of the risks, you likely will not have to make significant changes on a year-to-year basis (other than rebalancing). If you would rather leave the portfolio selection to professionals, select a no-load mutual fund family with a good performance history and low costs that offers target-date retirement funds and/or balanced funds (i.e., funds that maintain a predetermined mix of equity and income investments). You are likely to have more consistent and better results.

Contact Elliot Raphaelson, a certified court mediator in Florida with experience in estate planning, at elliotraph@gmail.com.